Swap execution facilities: A catalyst for OTC change?

Written by Jim Myers, Kimon Mikroulis and Paul Gibson of Sapient
Global Markets

SEF trading and the
"electronification" of the OTC marketplace are still in their
infancy. From the SEF trade volumes published to date, it seems
likely that established interdealer brokers and firms with
significant pre-SEF volumes appear poised to "win" the first
phase of mandatory SEF execution. Newly established SEFs have
struggled and will be forced to specialise, differentiate and
innovate with value-added offerings.

There is a significant
likelihood that many former dealers will increasingly depend on
a more fee-based revenue model, which could include charges for
execution, connectivity, clearing and collateral management
services.

One key trend to
observe over the coming months, alongside SEF aggregation and
new business models for banks, is the convergence of OTC and
exchange-traded derivative (ETDs).

There is a view among
some market participants that demand will shift away from OTC
trading on SEFs due to increasingly onerous regulatory
requirements and move toward ETDs, specifically swap futures.
Swap futures are designed to mimic standardised OTC swaps but
have reduced margin requirements relative to cleared
swaps.

While there has been an
increase in the volume of swap futures, this trend does not
necessarily reflect a wholesale shift away from OTC products.
In fact, results from ISDA’s recent survey of 245
market participants on the economic value of OTC derivatives
imply they are becoming a more popular form of risk management:
80% of respondents expect to use them going forward
[i]. In this context,
the differences between OTC swaps, swap futures and other
exchange-traded derivatives are significant.

Among the most
important are the hedge accounting rules, which are commonly
used by swap users to mitigate undesirable earnings volatility
caused by mark-to-market valuations. This relief to the
mark-to-market rules is only available if the hedging party can
clearly document the ability of the hedge to mitigate an actual
risk.

With the
standardisation inherent in a swap futures contract, the risk
mitigation argument is significantly more difficult to make due
to a standardised contract’s inability to mirror
the precise risk factor.

Additionally, there is
significant uncertainty around the way in which the IRS will
treat these futurised swaps for tax purposes. These
differences, along with the uncertainty around the long-term
regulatory treatment of swap futures, have proven to serve as a
disincentive toward broader and faster adoption of swap futures
products.

Price discovery on SEFs
can occur through a request for quote (RFQ) or central limit
order book (CLOB). To date, the vast majority of current SEF
volume is conducted using the RFQ methodology, which is
relationship based and follows an on-demand market-making
principle. CLOBs, which are common in the ETD and equities
world, are characterised by a continuous stream of prices on
both sides of a market. CLOBs are common in products with high
volumes and liquidity.

At this point, it is
unclear as to the role that CLOBs will play in the evolution of
the SEF markets. In the listed space, quotes of small notional
value are often streamed into a CLOB. As a market participant
seeks to execute a transaction, he or she would submit an RFQ.
As other market participants respond to the RFQ, the width of
the market would tighten and the size available to trade would
increase. This is a likely first step in the creation of a CLOB
on a SEF.

With their unique
market structure, SEFs can connect to multiple CCPs and market
participants can connect to one or more SEFs either directly or
through an FCM. Given that products are fungible on the CCP
level, the choice of SEF is unimportant. Over time and as
market participants get over their initial frantic onboarding
to SEFs, best execution in terms of price will become more
important, as will terms common in listed products, such as the
width and depth of the market. The SEFs able to foster the
creation of these "best markets" will be the long-term winners
in the space.

The single largest area
of convergence may well lie in the impact of electronic trading
on the OTC market. While mandatory electronic trading is still
in its infancy, there are some signs that those familiar with
the transition to electronic trading in the listed space will
recognise.

New entrants and former
market takers who have not previously acted as OTC market
makers are beginning to change the market and bring their own
version of aggressive market making, speed and risk management
to bear. Market takers are increasingly requesting RFQs from
the entire market and not just from those dealers with whom
they have prior relationships.

There has been evidence
that some traditional buy-side firms have been actively "making
markets" for other buy-side firm’s RFQs resulting
in a new "all-to-all" market paradigm. Many market participants
are anticipating continued rapid evolution over the course of
the next twelve to eighteen months.

Jim Myers is a
senior manager of business consulting based in Chicago, Kimon
Mikroulis is an associate and Paul Gibson is a business
consultant, both based in London at Sapient Global
Markets.

[i]ISDA AGM to Highlight Economic Value of OTC
Derivatives; Survey Finds Derivatives Are Important to
Almost 90% of End-Users’ Risk Strategy,
http://www2.isda.org/news/isda-publishes-research-papers-on-the-value-of-otcderivatives